Are Generic Drug Stocks The Cure For A Hung-Over Health Care Market?

Feeling a little hung-over? If you've been following the wild gyrations of government policy in the health care space, you could easily be feeling that way.

Don't look now, but we've entered the Twilight Zone of Obamacare. It's data cherry-picking season in Washington D.C., meaning that while the Affordable Care Act is fully upon us, there's still no reliable information available on how many Americans have purchased it.

Worse yet, we also have no idea what kind of people have actually enrolled. Are they the coveted young and healthy? Or the walking dead?--as Conan O'Brien, that self-appointed Obamacare pundit likes to call them. O-Brien apparently hasn't heard this one yet, but in Kentucky you can even sign up someone who is dead. As reported by various media sources, the application form in Kentucky asks if the application is for someone who has recently died. If you click the "yes" box, you can enroll them.

In short, we're in a period that Rod Serling would have gleefully featured on his classic Twilight Zone series. Confusion rising from the new health care law is like a dark cloud spreading across the United States. But don't hum the theme song from the Twilight Zone yet. While the policy wonks are feverishly picking apart the Affordable Care Act's dense tangle of thorns, and President Obama's hair is getting grayer ever day, health care investors have some unprecedented opportunities.

With all the free "taxpayer money" floating around, one thing is certain. Some companies in the health care space are going to get insanely rich this coming year, while others are going to get ripped to shreds. Health care investors, naturally, want to be on the side of the angels with this one. But that requires knowing whether the new health care law is workable, or whether it's headed for a death spiral.

And right now, frankly, that's impossible to tell.

We'll have better data soon enough. In the meantime, how about taking a pause from trying to guess the short-term direction of various highly sensitive Obamacare health care stocks? There's a better place to be investing in health care right now, the generic drug companies. Putting your mind (and dollars) to work in this upstart health care sector could not only save your sanity, but bring in some big profits.

One thing is certain. Whatever changes may be ahead with the Affordable Care Act, companies like Actavis (ACT), Valeant Pharmaceuticals (NYSE:VRX), and Perrigo (NASDAQ:PRGO) aren't going to suffer much. Those stocks are ikely to continue their great run straight into 2014 and beyond.

Here's why.

Generic Drug Stocks Are Licking Their Chops for 2014

Most investors are aware of the patent cliff--how $133 billion in brand name drug sales will lose patent protection in the six-year period between 2011 and 2017. The patent cliff has changed the game for big pharmaceuticals. While many of the big pharma stocks did well in 2013, 2014 doesn't look nearly so promising. Big Pharma has been traditionally regarded as the safe place to be long-term, but Eli Lilly (NYSE:LLY), for just one example, has become highly risky. The company is facing a monumental uphill battle this coming year. On January 7, Eli Lilly's earnings guidance took a precipitous drop, mostly due to the patent expiration of Cymbalta, the prescription depression drug.

Even Pfizer's (NYSE:PFE), which had a great year in the market last year, has seen its profit continue to fall ever since it lost Lipitor. The company's loss of patent protection on its top-selling blockbuster has been the major reason for the company's nearly 7% year-over-year decline in revenue. And despite all of Pfizer's maneuvering to worm its way back into the Lipitor game, including entering into a so-called pay-to-delay deal with Ranbaxy, a generics maker, Pfizer's pharma business is unlikely to ever recover to its top-line levels of 2010. This is not going unnoticed. In gurufocus.com, Pfizer is now among the list of stocks the most gurus sold while the fewest bought.

We're talking about a long-term decline of these company's core businesses, but amazingly, they seem unprepared for it. One of the most popular strategies being used to deal with the patent cliff? Get smaller. You read that right. Despite having known the cliff was coming for decades, Big Pharma seems to have resigned itself to shedding employees and facilities. Correspondingly, they have put relatively little effort into what might actually make them grow--creating genuinely new drugs.

For example, Pfizer's research building in New London, Connecticut once housed 2,000 employees. The facility now belongs to Electric Boat and houses employee working on nuclear submarines. Merck announced a workforce reduction of 8,5000 layoff last fall. AstraZeneca, Novartis, AbbVie, have all announced reductions of at least 5,000 in the past six months.

As it stands, Big Pharma spends more of the revenues (25%) on marketing than on discovering new molecules (1.5%). The overall spending of Big Pharma on R& D is higher, but it mostly involves minor tweaks to existing drugs, designed to grab a slice of an existing market, rather than offering a new and genuine therapeutic intervention.

According to IMS research chief Michael Kleinrock, "We should expect fewer mega-blockbusters and more high-priced specialty and orphan treatments." He notes that compared to the early 2000's, when there were forty or more roll-outs per year, the rollout rate will likely be in the high single or low double digits for the foreseeable future.

Let's not mince matters. The patent cliff has dealt a tremendous blow to Big Pharma. Many of these companies are betting the farm on making acquisitions of smaller companies with promising drugs in Phase II and II trials. But the jury is still out on whether they are rich enough to buy themselves a future.

Remember that TV advertisement for Wendy's called "Where's the beef?" The one where the old lady pokes at an exaggeratedly large hamburger bun that tops off with an incredibly minuscule hamburger patty?

That's the way I've been feeling researching Big Pharma companies recently. (It certainly is a big bun. It's a very big bun. It's a big fluffy bun. It's a very big fluffy bun.")

You get it.

While Big Pharma's top line is getting hammered, generic drugs know they've got one of the biggest drug deals in history coming their way this year. Some observers believe that 2014 will be the most profitable single year of the six-year patent cliff for generics.

Here's what's up for grabs in the next twelve months. The list includes some of the biggest blockbuster drugs in history: Nexium, Cymbalta, Celebrex, Symbicort, Lunesta, Restasis, Evista, Sandostatin LAR and Actonel. Novartis (NYSE:NVS) is losing exclusivity on Sandostatin LAR and ExForge. Allergan is defending a patent on Restatis and Lumigan. AstraZeneca's (ADR) famous "purple pill" Nexium for acid reflux treatment goes off patent in May, 2014. AstraZeneca is also going to lose Symbicort's patent for a combination inhaler.

I could go on, but here's the key takeaway. Generic companies can legally release copycat versions of these drugs the moment the legacy patent expires. And since the generic version typically capture 80% of the market share within the first year, the shift in top line growth from legacy Big Pharma to upstart generic is immediate and immense.

If that wasn't enough of a catalyst, generic drugs reduce costs for consumers from 30% to 80%. That's not always a great thing for these companies, by the way. Teva Pharmaceuticals (NASDAQ:TEVA) is best known for its generics business, but it also owns a sizable large specialty pharmaceuticals business. In an ironic twist, Teva's biggest drug in its specialty portfolio is Copaxone, a blockbuster multiple sclerosis drug that generated $1.05 billion in sales last quarter. Teva's key patent for Copaxone will expire in May, 2014. For this and other reasons, TEVA is one stock I certainly am not recommending in the generic drug space.

On the other hand, the release of Copaxone will be a great relief for MS patients, who currently pay up to $40,000 for the drug annually.

Some generics are simple, some are complicated, some (like Teva) are strong sells, others are strong buys. In terms of potential for major growth in the years and even decades ahead, here are three stocks to put on your radar screen.

Valeant Pharmaceuticals Lifts Off

Some of the generic drug stocks are beautifully executing their strategies and have a prescience about change that is unusual. Valeant Pharmaceuticals, in particular, just keeps getting it right.

Valeant Pharmaceuticals jumped 11.30% on January 7, after CEO Michael Pearson provided strong guidance for 2014. Pearson said that Valeant expects to generate revenues of $8.2 - $8.6 billion in 2014, up 40% from 2013. He also said he expects Valeant's market capitalization to climb into the top five drug companies by the end of 2016.

Pearson may actually succeed at his lofty goal two-year goal. The company is well known for its take-no-prisoners approach to acquisitions. Valeant acquired Bausch &Lomb in August, 2013, Obagi Medical Product a few months before that.

Valeant plans to complete their integration of Bausch &Lomb in 2014. Valeant placed a big bet on an aging patient population and increasing demand in emerging markets for eye health products with this acquisition--and that bet is likely to pay off.

Just a month ago, in December, Valeant also entered into a definitive agreement to acquire all the outstanding common stock of Solta Medical (NASDAQ:SLTM). Unlike its other acquisitions, this one should be immediately accretive to Valeant's bottom line.

In the meantime, Valeant keeps churning out new products. They recently received approval from FDA for Luzu cream, a topical treatment for a variety of skin diseases. The company has a return on equity of 7%, and a pretax margin of 41%. Earnings per share, on a cash basis, are expected between $8.25 and $8.75.

Valeant is a complicated company, but it's a stock you absolutely can't ignore. The Canadian-based company follows a unique plan written by Pearson when he ran consulting giant McKinsey & Co's health-care practice. The Valeant board asked for his advice in 2007, and hired him as a CEO a year later to put his strategy into play.

Thus far, Pearson has delivered. Over the last ten years, the company has produced 24% per year to investors while the overall market has delivered only 5%. Pearson prefers products that have modest sales--and are less likely to attract rivals, and that aren't covered by cash-strapped public health plans.

It should be noted that Valeant is not a stock for the faint at heart. Shares of VRX reached a 52-week high of $118.25 during the course of the trading session on December 31, 2013. That represented a 96.4% year-to-date return. It fell off a little after that, but (as of January 7) has jumped to 128.30 based on the enthusiastic guidance.

On a price-to-sales ratio Valeant is traded at 8.3X, which is a huge premium compared to a peer group average of 3.15X. On a price-to-book basis, the stock is also trading at a premium to the peer group average. The big question is whether this company has gotten ahead of itself.

Market strategist Bill Gunderson wrote an insightful article that discussed Valeant a few days ago. He gave high marks to Valeant for performance, and a value grade of "B". It should also be noted that Valeant has long been rumored to be a takeover candidate for Activis.

It has a return on equity of 7%, and a pretax margin of 41%. Earnings per share, on a cash basis, are expected between $8.25 and $8.75.

Valeant's constant deal-making can be hard to keep track of for investors, but like other acquisitive firms, the most important thing to do is pay attention to whether it is able to work its formula successfully.

Perrigo Looks Almost Perfect

Perrigo is one of the world's largest health care suppliers. It sells store-brand versions of popular treatments from Johnson & Johnson (NYSE:JNJ) and GlaxoSmithKline (NYSE:GSK) at lower prices. The company got a nice boost last year from J& J's manufacturing problems at McNeil, and the ensuing wave of recalls.

Perrigo is a solid company, and it greatly outpaces both Johnson and Johnson and GlaxoSmithKline in sales growth, but it made a controversial acquisition in the early fall of 2013 that caused the stock to stumble. (The stock has since recovered and moved substantially higher.)

The acquisition was the purchase of Irish-based biotech Elan Pharmaceuticals (NYSE:ELN). The deal was widely misunderstood and even mocked. Perrigo paid Elan $8.6 billion in a stock-and-cash deal, despite the fact that Elan's CEO Kelly Martin had already spun-off or sold most of the company's assets.

Critics argued that all Perrigo got for their $8.6 billion was a shell and Tysabri royalties. The critics were correct, but that's exactly what Perrigo wanted and needed.

The deal combined the advantages of stable royalty payments on the multiple sclerosis treatment drug Tysabri, and the chance to re-domicile in tax-friendly Ireland. Corporate tax rates are just 12.% in Ireland compared to 35% in the U.S. Perrigo can also offset $2 billion in profits against the tax deductions in Ireland.

Perrigo has a market cap of $14.6 billion and a P/E ratio of 32.36. According to their earnings results on October 31, earnings per share (NYSEARCA:EPS) for the quarter beat the consensus estimates of $1.40 by 12 cents. The company's revenue for the quarter was up 21.3% on a year-over-year basis. On average, analysts predict that Perrigo will post $6.62 earnings per share for the current fiscal year.

Perrigo is known mostly for selling store-brand cold medicines, allergy drugs and infant formula, but it also has a promising new partnership with Teva Pharmaceuticals to launch a copycat version of Temodar, a brain cancer drug going off patent from Merck.

Research analysts at RBC Capital just initiated coverage on Perrigo on January 8th. They made the firm a "top pick" with a $187.00 price target.

Actavis Has Its Act Together

The stock performance of Actavis has been tremendous over the past two years. After a little flurry in the social media on January 7 (as noted by Trade-Ideas, who benchmark such things, believing they foretell coming news or jumps in stock price) Actavis announced that its generic version of Micardis had received FDA approval.

As a first applicant, Actavis is eligible for 180 days of generic market exclusivity with their copycat version of Micardis. The drug is used in the treatment of hypertension. For the 12 months ending September, 2013, the legacy version of Micardis had total U.S. sales of approximately $274 million.

Actavis is the world's largest generics prescription drug manufacturer, and it's on track for a continuing strong run. The company's pharma business grew 70% in its last quarter, mostly due to the generic (also called biosimilar) launches of such drugs as Lidoderm, Lamictal, Nucyna, and Suboxone. All of these drugs are the fall-out from patent expirations in late-2012 through 2013.

Actavis has had six straight years of earnings growth. For the last three quarters it has met analyst expectations, beating them for one quarter out of the last four. Last quarter its revenue growth jumped 56.6%, greatly exceeding the industry average of 2.3%.

The company has some notable weaknesses. Despite stellar revenue growth and good cash flow from operations, revenue does not appear be trickling down to the company's bottom line--as displayed by last quarter's decline in earnings-per-share. Return-on-equity has also decreased when compared to its ROE from same quarter one year ago. While it's certainly pricey at 3.8 times sales, analysts expect sales to grow 22% this year.

It should be noted that as recently as a year ago Actavis was known as Watson Pharmaceuticals. The company took the name of an acquisition target, Activas, thinking that would provide better brand recognition in the global generics market. Currently, there are 12 analysts that rate Actavis a buy, no analyst rates it a sell and three rate it a hold. Like Perrigo, Actavis has also left the U.S. for tax purposes, reincorporating in tax-friendly Ireland.

What Clouds are Looming Over the Generic Drug Space?

The biggest risk to generic drug companies are the incessant legal maneuvers and delay tactics big pharma uses to try to hold on to their patents.

Unfortunately for consumers, all the legal shenanigans slow medical innovation. Big Pharma spends millions on litigation that could be spent on developing much needed new drugs. And it's likely the actual amount totals into the billions, since the pharmaceutical industry is the biggest lobbyist on Capitol Hill, with a total of $2.6 billion spent on lobbying from 1998 through 2012, mostly trying to protect pricing strategies around drug patent rights.

What does it gain them? Not much, as it turns out. According to Diana Papshev, a partner with DrugManagementForum.com, generic manufacturers that summon up the courage to fight a court battle with a legacy drug company's patent extension win in court about 75% of the time.

The Supreme Court handed a huge loss to Big Pharma around patent rights last year. In June, 2013, the Court decided the Federal Trade Commission could indeed sue Big Pharma companies that were bribing certain generic companies to keep competing drugs off the market.

The more ethical generic companies cheered when the decision came down, but it doesn't mean the fight is over. New schemes and huge legal battles will proliferate as the entire industry nears a tipping point.

I'm not worried about the generics however. This is what they do best. They survey the battlefield. They scrabble for weapons. They summon courage. They change the rules.

The 2014 stock year is off to a bumpy start. I asked my druggist today, and he told me around eight in ten prescriptions he fills are for generic drugs. Instead of feeling hung-over, maybe we should all take a Tylenol. No, let's try a generic Acetaminophen. It could be the cure to what ails us.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.